Archive for the ‘Economics’ Category

As a follow up to my last post (“U.S. government operations can be incredibly complex”), I wanted to provide a chart of the new U.S. health care system. Healthcare represents 17% of the U.S. economy. Unfortunately, Obamacare was passed with no one having actually read the bill.

Obamacare is modeled on Romneycare, the system in place in Massachusetts since 2006. In the several years since Romneycare has gone into effect, healthcare costs have soared far beyond the national average. Massachusetts now has the highest health insurance costs, the highest medical costs, the fastest rising costs and the longest waits for doctors in the nation.

Complexity itself is a major problem in organizational function. The chart below does not bode well for the nation as a whole. A larger version of the chart can be accessed here.

Congress passed, and President Bush signed on October 3, the Emergency Economic Stabilization Act of 2008, H.R. 1424 (the “Act”). The purposes of the Act are twofold: It authorizes the Secretary of the Treasury (the “Secretary”) to restore stability and liquidity to the U.S. financial system and to do so in a manner that protects home values, college funds, retirement accounts and life savings; preserves home ownership and promotes jobs and economic growth; maximizes overall returns to American taxpayers; and provides public accountability to the exercise of that authority.

That’s a tall order. The key provision involves a Troubled Asset Relief Program (“TARP”). Under this program, the Secretary, through an office of Financial Security that is to be established, may purchase up to $700 billion in financial institution assets. The assets must be residential or commercial mortgages or securities, obligations or other instruments relating to such mortgages originated on or before March 14, 2008 or other financial instruments that the Treasury determines necessary. They may be purchased from all U.S. institutions of all sizes, including the licensed U.S. branches and agencies of foreign banks. The Treasury can manage and sell the assets or enter into financial transactions regarding any purchased asset.

Some other provisions that sought to increase financial stability include an increase in FDIC deposit insurance from $100,000 per account to $250,000 per account until December 31, 2009 and an authorization for the SEC to suspend mark-to-market accounting.

The Act also included a number of unrelated provisions relating to tax relief, tax cut extensions, an R&D tax credit, tax incentives, mental health and creating environmentally-friendly jobs, among others.

We’ve had many years of low inflation in the United States. In the past year, however, inflation has increased. The U.S. economy is complex and many reasons are behind this acceleration. For example, the industrialization of the economies of China and India have increased the demand for commodities, which are used to build infrastructure. So the prices of commodities, such as steel and oil, have risen as demand has increased globally.

The law of unintended consequences also has played a part in inflation. Congress passed and President Bush signed the Energy Independence and Security Act, which mandated a huge boost in the use of corn-based ethanol. This occurred at a time when world grain stocks are at a 30-year low and prices at historic highs. With more demand for corn, prices shot up. Livestock producers and food processors incurred greater costs, as corn is a staple of livestock feed. As a result, the cost of food rose and now, for example, eggs cost 40% more than they did a year ago. In fact, even the prices for non-food crops rose as farmers switched from them to grain crops, which are more lucrative.

So what holds value during inflationary times? Hard assets typically do. One such hedge against inflation is real estate. Despite the housing downturn due to the subprime crisis and resultant credit crunch, real estate historically has been a good long-term investment when inflation accelerates. Although the market is not at its peak, we haven’t seen a decline in U.S. commercial real estate comparable to the residential slump. Good value may lie in commercial real estate investment over the next few years.

How can a failure in one market snowball and create failures in others? Here’s a simplified example, in the case of auction rate securities (ARS).

Much has been written this year about the sudden illiquidity of the ARS market. ARS are a product often used by companies to invest their excess cash. The inability to properly value such securities led to problems because they need to be properly valued on a company’s balance sheet for financial reporting. Additionally, when that cash was needed, reselling the ARS at what was their supposedly appropriate value was an issue, as they were trading at significant discounts because of market illiquidity.

An ARS is a debt security, most often a municipal or corporate bond, in which the interest rate is reset via a Dutch auction on each payment date. Essentially, it is a long-term bond with a 20 or 30-year term, but with variable interest rate, so that it acts like short-term debt. A Dutch auction, also known as a descending price auction, is the winning bid at which the lowest possible interest rate at which equilibrium occurs (equal numbers of buyers and sellers exist), such that all securities can be sold. For ARS, the auctions to reset the interest rate usually are held every 7, 28 or 35 days.

In February, 2008, the market for ARS collapsed and more than 1,000 auctions failed. This is because the ARS’ insurers were in financial difficulties because they previously had insured mortgage-backed securities that were now defaulting at higher rates. Suddenly, the ARS were seen as riskier because the insurers backing them were less secure. Although an auction may fail, the ARS’ rates do reset, typically increasing to the maximum rate allowed for the issuer of that particular ARS. Demand for the securities decreased. The investment banks that make a market in these securities refused to act as bidders of last resort, which they previously had done. Consequence: the market for ARS froze.

Investment banks had pitched these securities as “cash or cash equivalents” to companies. But cash and cash equivalents are considered liquid. Suddenly, many companies which held ARS had to revalue their holdings, and some reclassified them as short-term investments. These changes reduce cash holdings on the balance sheet. In some cases, a company may technically default on its debt covenants based on the ratio of cash on its balance sheets. Public companies with significant amounts of ARS as a percentage of cash could see a drop in their share prices.

Even if the issuer underlying a particular ARS is fine, the lack of liquidity and auction failure created problems for investors. These problems, with began with the failure of mortgage-backed securities, spiraled into auction rate securities, affected companies’ balance sheets and perhaps, share prices. This, simply put, is how the failure of one market can snowball into other markets.

A month ago, I wrote about the emergence of China and India in the world economy. Their expansive growth, though, results in their being more greatly affected by global economic trends. As Investor’s Business Daily notes in U.S. Slowdown Shows In Drop of China ETFs, lower consumer confidence and drops in spending among American consumers has hurt Chinese economic growth. That’s because the U.S. is the largest export market for Chinese goods.